As £7 billion worth of rights issues hit the market, with the promise of more to come, shareholders are increasingly being confronted with a decision about whether to take up their allocations. While investors should not unquestioningly use their rights to buy shares in a company if it announces an issue nor should they dismiss the prospect out of hand. There are instances when it can represent a turning point in a firm’s fortunes.

The trend of the last decade towards so-called de-equitisation, the replacement of equity with debt, and the preference for ‘efficient balance sheets’ has reversed in the wake of the credit crunch. And the current wave of rights issues, at significant discounts, principally involve companies which had become highly geared because debt was, until recently, so cheap relative to equity.

Size matters

But which rights issues should existing investors subscribe to, and which ones should you avoid? Research from Morgan Stanley suggests the size of the rights issue is an important consideration. They found companies that have raised cash equivalent to 50% or more of their market capitalization saw their share prices rise in absolute terms over the following two years. On this basis investors in £6.2 billion cap Xstrata (XTA) may wish to participate in the massive £4.1 billion rights while rumoured sizeable rights issues at Debenhams (DEB), Wolseley (WOS) and Premier Foods (PFD) may present good opportunities for existing holders to top up (see table 1).

While the immediate drop in share price following the announcement of a deeply-discounted fund raising can be scary, the fact remains if you do not want to take up your rights you will be able to offset the dilutionary impact of the newly issued shares by selling your rights (see ‘Understanding rights issues’ for more details).

Longer-term benefits

Looking past any short-term share price dip, investors have to ask themselves what are the longer term benefits of the capital raising. Morgan Stanley’s UK equity strategist Graham Secker and his team looked at the 115 largest rights issues in the UK over the past 15 years,and they concluded the best long-term performers are companies that:

• raise a large amount relative to their market value

• have performed poorly in the prior year

• use the cash to repair/strengthen balance sheets

In relation to the third point, companies that have been performing well and are raising relatively small sums of cash to fund acquisitions or capital expenditure programs tend to underperform in the long run.

This backs up the analyst’s argument the bigger a rights issue is now, the better the longer-term outcome. Xstrata could fall into this category although new investors will have missed the chance to participate in the rights issue as the ex-rights date (the point at which anyone buying the shares would not have the right to purchase the newly- issued stock) passed last week.

Secker also observes ‘the median stock that raised cash equivalent to more than 75% of its market capitalization outperformed the market by 45% over the next two years and outperformed its sector by 58%’. He adds every stock that underperformed the market by 50% or more in the year prior to its right issue outperformed the market and its sector over the next two years. Life assurer Legal & General (LGEN) – which despite denials from management has been the subject of rights issue speculation – could be one to watch here barring a significant short-term share price rally

Sensible option

There are reasons why subscribing to rights issues makes sense. Perhaps most importantly, by addressing the financial difficulties the company is facing, a rights issue actually reduces the overall risk of a shareholder’s investment. In the case of Xstrata’s two-for-one rights issue will reduce its debt by 22% to a still large but more-manageable figure of £9 billion. A concurrent deal with its largest shareholder, Swiss commodities trader Glencore, to buy a coal mine for $2 billion has attracted controversy. With the acquisition being seen in some quarters as a ‘cheap loan’ to the latter to enable it to take up its rights.

Another reason why a rights issue might be a buy signal is speculation about the prospect of one and the anticipated impact of the dilution has, at least in some cases, already driven the share price down to a particularly low level. A short-term trading strategy of selling on the rumour and buying on the announcement of an issue could be successful. For example materials engineer Cookson Group (CKSN) was down 20% in the week leading up to the announcement of its £240 million rights issue on 29 January but then rallied more than 65% to a high of 141.5p after it was announced. In this case though, when the extent of the dilution became apparent as the shares went ex-rights Cookson’s share price began to fall rapidly again.

It would also be foolish to ignore the problems the company in question was facing prior to raising the cash as there is a danger it will not prove sufficient to resolve these. This certainly looks to be true of Cookson for, as Oliver Wynne Jones from Panmure Gordon observes, it is likely to see ‘further deterioration in trading conditions’.

Equity fund raisings proved insufficient to adequately recapitalise the banks – a sector which saw a number of rights issues last year, ahead of the rest of the market. The £4 billion issue at HBOS last April was probably the nadir – seeing, as it did, the lowest uptake of any attempted in Europe this decade. In light of what has happened to the banking sector in the last 18 months though it is probably fair to regard it as anomalous to the rest of the market.

Streamlining

The difficulties faced by the banks in getting their rights issues away has led the Financial Services Authority (FSA) to consider streamlining the process with companies likely to have to give shareholders a minimum of 10 days to make their decision to buy new shares or sell their rights. This is far shorter than the previous 21 days and less than the 14 days previously considered by the regulator.

If a sector has already seen a number of rights issues – as has been the case with real estate – then this could be taken as a bearish signal for constituents who have not already come to the market as ‘rights issue fatigue’ sets in. This has been reflected in the 58% fall in the share price of Workspace Group (WKP) since announcing its fundraising of £87 million. Peer Brixton (BXTN) has seen its share price plummet since the end of January, down by 54%, after it refused to rule out a rights issue.

Elsewhere in the sector Hammerson (HMSO), which has actually raised money, has been under pressure with the market apparently unsure about whether or not the £584 million it is raising will prove sufficient to weather the current economic environment.

It is worth bearing in mind economic conditions have arguably been more benign over the last 15 years than they are today. But even apart from Morgan Stanley’s conclusions the evidence would suggest, from the point of view of investors, if a group is going to raise cash through equity a rights issue compares favourably with the alternatives.

Shareholder benefits

Pre-emption rights of shareholders are protected in a way that is not true of other solutions such as share placings or cash raised by selling stakes to private equity firms or sovereign wealth funds. The preference for rights issues was evident in food producer Premier Food’s (PFD) decision, in the face of investor pressure, to abandon a plan to sell a stake on favourable terms to a major private equity fund and instead concentrate on its £400 million rights issue. Observers have suggested the decision to abandon the sale was in part informed by what has happened at debt-laden miner Rio Tinto (RIO).

Chinese aluminium producer Chinalco agreed a deal with Rio to inject £13.5 billion in the company through a convertible bond issue and acquisition of minority stakes in nine mines. The agreement prompted the resignation of chairman-elect Jim Leng – with the widespread view a rights issue would have offered the best solution to existing shareholders. Similar sentiments were expressed in response to Barclays’s (BARC) decision to raise billions of pounds from state-backed funds in the Middle East last year.

All of the above suggests while a rights issue is unlikely to be welcomed with any great fanfare by the market it represents a better deal for shareholders than many of the other types of fundraising used by companies. In select cases, where particularly large amounts of cash is being raised, they may also represent a good opportunity to top up holdings. N

Understanding rights issues

To the uninitiated the effect a rights issue has on the share price and their potential options in the face of one might represent something of a mystery – but the process is actually relatively simple.

The transaction involves the company giving existing shareholders the right to subscribe to newly issued shares in proportion to their existing holdings: for example a 1:6 (one-for-six) rights issue means an existing investor can buy one extra share for every six they currently hold.

A shareholder has four main options when confronted with the prospect of a rights issue. They can:

• take up the full allocation of their rights

• sell all of their rights

• sell part of their rights (and potentially use the proceeds to buy the remainder – known as ‘swallowing the tail’)

• do nothing and allow their rights to lapse – in which case the company will package the rights and sell them on, with the proceeds being returned to the shareholder

The price of the newly-issued shares is fixed, and is nearly always set below the prevailing market price. In order to calculate the price the shares should, all things being equal, fall to after a rights issue analysts use a calculation known as the theoretical ex-rights price (TERP).

How does this work? Well lets suppose an investor holds 100 shares in company X. The market price of the shares stand at 100p and the company then announces a ‘one-for-two’ rights issue (i.e. a shareholder can buy one share for every two he already owns). The subscription price for the extra shares is set at 80p.

The value of the investor’s holding before the rights issue was £100

(100 x 100p). If they decide to take up their full allocation they would have to buy 50 shares at the new price of 80p. In that case the amount of cash passing from investor to company X is £40. In order to arrive at the TERP we have to divide the new total value of the investment by the number of shares. In this case £140 divided by 150 which is 93p.

In reality, the share price will also be affected by what motivated the rights issue and the company’s particular circumstances at that time. But if, in the example of company X, our shareholder decides they do not want to take up their allocation, they will still hold 100 shares but at the theoretical ex-rights price of 93p. The total value of their holding will be £93 – down £7 on their initial holding.

If they sell their rights, which should be worth the difference between the subscription price and the ex-rights share price – in this case 13p (93p – 80p) they should be able to recoup the majority of this £7 (50 shares at 13p is £6.50).

The other alternative would be to allow their rights to lapse. But these shares are only sold on by the company once the rights issue is complete, with the cash then passed back to shareholders. If the share price has moved lower in the interim the value of the rights will have diminished.

Earnings per share and dividend per share numbers also have to be adjusted in the wake of a rights issue but they are often associated with other changes that may distort these numbers, such as paying off debt or expansion.

Clearly if, after it has been announced, the share price has fallen below the level at which the rights issue is priced investors should not take up their rights as the shares would be cheaper to buy on the open market.